Budget 2009: Let’s Assume We Have a Can Opener

I first heard the best joke about economics in 1975. The teller was the nuclear physicist (and nuclear power advocate) Sir Phillip Baxter, and he told it in answer to a question I had asked at a public forum.The joke is:

A physicist, a chemist and an economist are shipwrecked on a desert isle, along with a container full of cans of baked beans.

The chemist says that if they can start a fire, he can calculate the temperature at which a can will explode.

The physicist says that she can work out the trajectory of the baked beans after the explosion, so that they can gather the baked beans and eat them.

The economist looks at them in disdain, and finally says Guys, you’re going about it the hard way. Let’s assume we have a can opener.

The can opener that was the centrepiece of today’s budget was the assumption that the Down Under version of the Global Financial Crisis will end in 2011-12, and that after it, the economy will experience above-trend growth of 4.5 percent a year for at least two years. Armed with this can opener, The Treasury can easily get out of the deficit jam it is now in: corporate tax revenues will grow by a quarter, unemployment will fall 1% a year from its 8.5% peak, and the budget can eke its way back to surplus by 2016.

This is a modified version of the can opener that Treasury has been using for the last decade, where its forecasts for the future were based simply on the assumption that the economy will always return to 3 percent growth after any short term disturbance. Normally they assume that the short term disturbance only lasts for the current year, and that the long run trend will reassert itself the following year.

The Treasury’s one concession to reality in this Budget was to add an additional year where growth was expected to be below average–so rather than forecasting 3% growth in 2010-11 as it would normally do, it assumed growth of 2.5% for that year. But it then assumed growth of 4.5% for the next two years.

Overall, Treasury is assuming that the deepest global recession since the Great Depression (its words) will reduce growth over a 4 year period by a mere 0.25 percent per annum.

Isn’t it marvellous what you can do with a can opener?

Reality is rather harder to cope with. Though I’ve had many years to get used to this, I still find it bizarre to read statements like the worst global recession since the Great Depression and see this juxtaposed with expectations of a shorter, shallower recession than that of the 1990s.

At least there’s a sense of give us a break, what else could we do? to the way Treasury attempts to justify its assumptions in this document:

The approach is also in line with that taken in budgets in the early 1990s when above-trend rates of growth were assumed as the economy recovered from recession.

Other countries are also assuming above trend growth in their forward estimates as their economies are expected to recover. The US, UK, New Zealand and Sweden are all adopting such an approach. (Budget Overview page 29)

That’s cold comfort to the rest of us however–all it really means is that most OECD Treasuries are hoping that the crisis just blows over, just as are our alleged economic managers.

And we are asked to trust a projection based on the experience of the 1990s, when this is the worst global recession since the Great Depression? Wouldn’t that mean that recent experience should be a misleading guide as to what to expect? Why not instead show us what happened back then?:

Oops. 4 years of falling output with the economy shrinking by 10 percent in 1930 alone? Even 1990 doesn’t look quite as good in the data as the Treasury describes it:

Then output fell by more than 1 percent in 1992, and though growth returned to trend levels after 3 years of below trend growth, it certainly didn’t bound up to 1.5 times the pre-recession average.

The Treasury, like the RBA, didn’t see this crisis coming–have a quick read of the 2008 Budget Overview and look for the word crisis; you’ll find it once in relation to housing. The Treasury’s prognoses on how long this recession might last, and how deep it will be, are no more than wishful thinking.

Unfortunately, guided by neoclassical economics, there’s little else that The Treasury can do: according to standard neoclassical theory, this crisis shouldn’t be happening. Only when they throw away the textbooks will they have any hope of understanding how the economy actually works.

Until that day, make sure your own can opener is working–and maybe even set aside a stock of baked beans.